ADM 2341 Chapter Notes - Chapter 12: Sunk Costs, Decision-Making, Income Statement

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27 Jan 2016

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1)eliminate costs and benefits that do not differ between alternatives. These irrelevant costs consist of sunk costs and future costs that do not differ between alternatives. 2)use the remaining costs and benefits that differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs. Costs that are relevant in one decision situation may not be relevant in another context. Thus, in each decision situation, the manager must examine the data at hand and isolate the relevant costs. Costs of equipment is sunk, insurance is sunk, depreciation is sunk cost of maintenance if equipment used is relevant, decline in resale is relevant. Total and differential cost approaches total approach requires constructing two contribution format income statements one for each alternative. The difference between the two income statements of equals the differential benefits shown at the bottom of the right-hand column. Current situation --- new situation --- differential costs and benefits.

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Tactical decision making

Tactical decision making means choosing among alternatives withan immediate or limited end in view. For example, a company mayaccept a special order for less than the normal selling price touse idle capacity. Tactical decisions tend to be short-runin nature; however, it should be emphasized that short-rundecisions often have long-run consequences. A general tacticaldecision-making model is outlined here.

1.	Recognize and define theproblem.
2.	Identify possible alternativesolutions to the problem, and eliminate any unfeasiblealternatives.
3.	Identify the costs and benefitsassociated with each feasible alternative. Eliminate the costs andbenefits that are not relevant to the decision.
4.	Compare the relevant costsand benefits for each alternative.
5.	Assess qualitative factors.
6.	Select the alternative with thegreatest overall benefit.

Identifying and comparing relevant costs and revenues is theheart of the tactical decision model. Relevant costs (revenues) arefuture costs (revenues) that differ across alternatives. (Revenuesare treated in the same way as costs, so we will simplify thediscussion by referring to costs.) All decisions relate to thefuture; so, only future costs can be relevant. In addition, thecost must differ from one alternative to another. If a future costis the same for more than one alternative, it has no effect on thedecision. Such a cost is an irrelevant cost.

Assume that Reeves Company is considering accepting a specialorder for $25 per unit when the normal selling price is $30 perunit. Reeves has enough excess capacity to make the order withoutdisplacing normal sales. The alternatives facing Reeves Company are(Select "Yes" for the statements that are applicable and "No" forthe items that do not apply):

Accept the special order.	- Select your answer -YesNoItem1
Reject the special order.	- Select your answer -YesNoItem2
Sell normal sales for $25 perunit.	- Select your answer -YesNoItem3

Choose which of the following are relevant in deciding whetheror not to accept the special order. (Select "Yes" for thestatements that are applicable and "No" for the items that do notapply)

$25 price.	- Select your answer -YesNoItem4
$30 normal price.	- Select your answer -YesNoItem5
Variable cost of making the unitsin the special order.	- Select your answer -YesNoItem6
Depreciation on factory equipmentused in making the special order units.	- Select your answer -YesNoItem7
Increased property taxes on thefactory building which are due while the special order would bemade.	- Select your answer -YesNoItem8

While cost and revenue information is important, otherinformation may be needed to make an informed decision. Thesenon-financial factors are termed qualitative and are often relevantin decision making. For example, in deciding whether to make acomponent in-house or purchase it from an outside supplier, thecompany may consider any difference in quality or in responsivenessto the company's production schedules.

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MULTIPLE CHOICE:

1. Which of the following is never considered in incrementalanalysis?

A. Incremental revenue

B. Sunk costs

C. Incremental profit

D. Differential costs

2. When deciding between two alternatives, the preferredalternative always has:

A. No opportunity costs

B. Greater revenues than the other alternatives

C. Less expense than the other alternatives

D. Greater incremental profit than the other alternatives

3. A company is trying to decide whether to keep or drop thesporting goods department in its department store. If the segmentis dropped, the manager will be fired. The managerâs salary, inrelation to the decision ti keep or drop the sporting department,is:

A. Avoidable and therefore relevant

B. Not avoidable and therefore relevant

C. Sunk and therefore not relevant

D. The same for all alternatives and therefore not relevant

4. A product line should be dropped when:

A. It has a negative contribution margin

B. Its avoidable fixed cost are greater than its contributionmargin

C. There will be a positive change in income if the product lineis dropped

D. All of above

5. Joint cost are:

A. The cost of the common inputs for joint products

B. Greater when there are more joint products

C. Unnecessary if the accounting system is moresophisticated

D. Only used when there are no opportunity costs involved in thedecision

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1. Which of the following costs is not relevant in aspecial-order decision?
A. Direct labor
B. Direct materials
C. Variable overhead
D. Fixed overhead

2. Costs that change across decision alternatives are
A. accounting costs.
B. activity-based costs.
C. incremental costs.
D. capital costs.

4. The potential benefit of one alternative that is lost bychoosing another is known as a(n):
A. Sunk cost
B. Out-of-pocket cost
C. Differential cost
D. Opportunity cost

5. A cost that cannot be avoided or changed because it arisesfrom a past decision, and is irrelevant to future decisions, iscalled a(n):
A. Uncontrollable cost
B. Incremental cost
C. Opportunity cost
D. Sunk cost

6. An additional cost that is incurred only if a particularaction is taken is a(n):
A. Period cost
B. Pocket cost
C. Discount cost
D. Incremental cost

7. The payback period:
a. Is the length of time necessary to recover the entire cost of aninvestment from its resulting annual net cash flow.
b. Is the length of time necessary to recover the entire cost of aninvestment from its resulting annual net income.
c. Takes into consideration the profitability of an investment overits entire life, but ignores the timing of its future cashflows.
d. Takes into consideration both the profitability of an investmentover its entire life and the timing of its future cash flows.

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ADM 2341 Chapter Notes - Chapter 12: Sunk Costs, Decision-Making, Income Statement

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